Rev. Rul. 80-24

1980-1 C.B. 47, 1980-4 I.R.B. 5.

                       Internal Revenue Service
                                 Revenue Ruling

           BAD DEBT; DISHONORED NOTE; CAUSE OF ACTION AGAINST SELLER

                          Published: January 28, 1980

Section 166.--Bad Debts, 26 CFR 1.166-2: Evidence of worthlessness.

(Also Section 61: 1.61-1.)

  Bad debt; dishonored note; cause of action against seller. A taxpayer purchased an unsecured bearer promissory note. On the due date, the note was presented for payment, but was dishonored. Legal action to enforce payment on the note would not, in all probability, result in satisfaction of execution of a judgment. The taxpayer has a cause of action against the seller that may require the seller to return the purchase price of the note. The taxpayer was entitled under section 166 of the Code to a bad debt deduction in the year the note was dishonored. If amounts are recovered by the taxpayer from the seller, they will be ordinary income under section 61.

ISSUE

  What is the proper year of deductibility pursuant to section 166 of the Internal Revenue Code of a bad debt incurred when an unsecured note of a bankrupt is dishonored if the holder has a cause of action against the seller of the note that may require the seller to return the purchase price of the note to the holder?

FACTS

  On July 1, 1974, X purchased from Z, a brokerage firm, an unsecured bearer promissory note issued by Y and payable June 30, 1975. X, Y, and Z are unrelated domestic corporations. The note was not issued with interest coupons and was not in registered form and therefore it is not a security within the meaning of section 165 of the Code.

  X presented the note to Y for payment on June 30, 1975, but it was dishonored.  On September 1, 1975, Y petitioned a United States District Court for bankruptcy under section 77 of the Bankruptcy Act (11 U.S.C. section 205). Legal action by X against Y or its successors to enforce payment on the note would, in all probability, as of September 1, 1975 or thereafter not result in satisfaction of execution on a judgment against the defendants.  Due to alleged misconduct by the seller, Z, when the note was sold to X, X has a cause of action against Z, one of the remedies of which is to rescind the contract of sale and to recover the amount it paid to Z for the note.  X's right to sue Z is based on the Securities Act of 1933, 15 U.S.C. section 77 (1970) and the Securities Exchange Act of 1934, 15 U.S.C. section 78 (1970), as well as state law provisions and it has a reasonable likelihood of succeeding.  X files its federal income tax returns on a calendar year basis.

  The specific question is whether X is entitled to a bad debt deduction in 1975, the year when the note was dishonored by Y.

LAW AND ANALYSIS

  Section 166(a)(1) of the Code provides that a deduction is allowed for any debt that becomes worthless within the taxable year.

  Section 1.166-1(c) of the Income Tax Regulations provides that only a debt that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money qualifies under section 166 of the Code.

  Section 1.166-2(b) of the regulations provides that whenever surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would, in all probability, not result in the satisfaction of execution on a judgment, a showing of these facts will be sufficient evidence of worthlessness of the debt for the purposes of the deduction under section 166 of the Code.

  In Zeeman v. United States, 275 F.Supp. 235 (S.D.N.Y. 1967), remanded for further proceedings on other issues, 395 F.2d 861 (2nd Cir. 1968), a brokerage firm was owed money by a debtor that was adjudicated a bankrupt in 1963.  The brokerage firm took a bad debt deduction in that year.  Numerous suits were brought in 1963 on behalf of the brokerage firm seeking damages for fraudulent transactions that caused the debt to become worthless.  The court held that recovery on these suits for damages would not be recovery on the debt, and, therefore, the pendency of the suits did not affect the deductibility of the bad debt loss in 1963 by the brokerage firm.  The court relied on the fact that none of the suits dealt with the debt owed by the debtor to the creditor or with collateral, guarantees or indemnity contracts directly related to the debt as such, although the damages claimed could be measured by the debt loss.

  In the present situation, X's cause of action against Z is based on the sale of the note by Z to X, and not on the debtor-creditor relationship between X and Y.  Any recovery would relate to the sale of the note by Z to X and would have no

bearing on the actual worth or collectibility of the debt evidenced by the note.

HOLDING

  X is entitled pursuant to section 166 of the Code to a bad debt deduction in 1975.  Further, if any amounts are recovered by X from Z they will be ordinary income to X under section 61(a).

Rev. Rul. 80-24, 1980-1 C.B. 47, 1980-4 I.R.B. 5.